Wednesday, June 25, 2014

Limits to arbitrage are real, yo

At Bloomberg, I talk about some cool research I saw at the Western Finance Association conference, and why it means we need to change regulation to make it easier for people to short-sell stock:

More finance journalists and industry people should go to academic conferences. There is a lot of good stuff to learn. Case in point: I recently attended the Western Finance Association’s annual meeting in Monterey, California, and saw several papers that changed my outlook on financial markets and policy. One of the most interesting was called “Short Selling Risk,” by Matthew Ringgenberg, Adam Reed, and Joseph Engelberg.

But first let’s back up and talk about a little history. Why should financial markets have bubbles, where asset prices soar above fundamental values? Eugene Fama and Milton Friedman thought that “arbitrageurs” -- rational investors -- would see the discrepancy and short-sell the asset in question until the price went back down to reasonable levels. But in the 1990s, economists such as Andrei Shleifer and Robert Vishny started arguing that no, this wasn’t always possible. Unlike going long, going short has extra costs. If going short is too hard, then arbitrage is limited; the optimistic investors will push prices up, and the pessimistic investors won’t be able to counteract them. Voila: bubbles.

What Ringgenberg and his co-authors do is to look at how short-selling actually works in real life -- in which an investor borrows shares and sells them, hoping to buy them back after a price decline -- and figure out what the costs of shorting really are. They find that there are two big costs that have been largely ignored...

10 comments:

I've often wondered why there isn't a market for pseudo stocks - that is, a type of bond in which the coupon payments match the dividend of a third party stock. That would be a different mechanism for shorting stocks, and one that creates extra supply of a stock in a bubble state.

Doesn't the conventional method of shorting stocks create extra demand for the stock - i.e. suppliers of stock to the shorters buy the stock to "short the shorts" so to speak, and the extra demand created by a market for short selling probably counteracts the downward price that the short selling has.

The companies in a bubble state themselves often supply extra stock to the market, but they are not motivated to hit a price supported by fundamentals, and they don't supply enough extra stock to alleviatge bubble prices.

"a type of bond in which the coupon payments match the dividend of a third party stock"

Isn't that just a funded dividend swap? But how is the market maker supposed to hedge this if they can't short the third-party stock? And if it's "third party", how can you prevent the underlying issuer ("first party") from gaming the market unless you can hedge with an issued security?

Synthetic supply = the "naked shorting" that there was endless whining about, leading to regulatory restrictions. A familiar pattern: an asset bubble is blamed on the very mechanisms that reign it in, provoking measures to remove them.

It's not the cost of short selling, there's a more fundamental asymmetry. Short sales contracts are of finite duration. You don't just maintain a negative share count or have an anti-matter shares certificate. When you buy, you hold until you sell.

This ignores the real reason for bubbles. It's not about short selling, it's about the process of price discovery which is built on Bayesian reasoning and has an inherent momentum. In a fair market, everyone shares the same priors, but they have different weighted expectations. As new information comes in, the priors are updated, and that means investors have to update their expectations. If the prices keep rising, even skeptical investors are going to have rising expectations. This is how we figure out what sounds are associated with what words. We do the same things for market prices.

So, how many times do you sell short before figuring that selling short is a bad bet? Based on the updated priors, the population of short sellers is going to thin. How many people are shorting Ford stock these days because they don't believe the automobile is going to catch on? Most investors shorting Ford have other reasons based on more recent information and that's where bubbles come from. It's just that they're not always bubbles.

Isn't that just naked shorting? If naked shorting were allowed, then nobody would have to worry about lending or all of that nonsense. Naked shorting would make bear raids easier, but if the data were published on a daily basis, it would make clear that it was bears providing the extra supply.

Naked shorting means that some people who think they own full fledged shares (with voting rights), actually don't. If everyone were willing to lend out their shares for nothing, this wouldn't matter, but in that case naked shorting wouldn't be advantageous.